EC It's An Option Buyer's Market

The fact that the current options market is unsustainable is what makes it so vitally important that folks pay attention to it. The fact that stock prices are still going up, even though ATM option buyers are profiting (when they normally do not profit) suggests the market has become irrational. It is pointless to argue with irrationality; much better to join in, knowing full well that it won’t last forever.

You are here – Bull Market Stage 1 – the “Lottery Fever” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending December 6, 2014, this is how the trades performed on the S&P 500 index ($SPY or $SPX):

  • Covered Call and Naked Put trading are each currently profitable (A+).
    This week’s profit was +2.9%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +3.3%.
  • Long Straddle and Strangle trading is currently profitable (C+).
    This week’s profit was +0.4%.

Options Market Stages

The combination A+ B+ C+ occurs whenever the stock market is at Bull Market Stage 1, the “Lottery Fever” stage, which gets its name from the irrational stock buying frenzy reminiscent of a lottery jackpot feeding upon the greed of ticket buyers hoping for a chance to win. The higher the jackpot the faster the ticket sales, and the faster the tickets are sold, the higher the jackpot.

The following weekly 10-minute 3-step process provides further analysis.

Weekly 3-Step Options Analysis: 

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (#CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

CCNPI 12-06-14

Historically, any time Covered Call trading has become unprofitable, a full-fledged Bear market has ensued within a few weeks to, at most, a few months. That makes the recent October dip into unprofitability, the first such instance in 3 years for Covered Calls, a major signal for the potential of an upcoming Bear market. As bullish as the current market may appear, traders should be open to the possibility that a Bear market is certainly not impossible.

The unprofitability of Covered Call trading does not guarantee that a Bear market will occur soon, nor does it imply that stock prices cannot rally much higher in coming weeks. Rather, it indicates that similar conditions as currently exist have always resulted in Bear markets in the past. Traders should be prepared for the possibility that the current rally is a trap. Even if it turns out not to be a trap, it is better to be safe than sorry.

If the S&P falls below 1938 over the upcoming week, Covered Call trading (and Naked Put trading) will become unprofitable, indicating that the Bears retain control of the longer-term trend. Above S&P 1938 this week, Covered Calls and Naked Puts would be profitable, which is normally a sign that the Bulls are in control. However, such control is usually only temporary as long as the Bulls lack strength and confidence.

The reasoning goes as follows:

  • “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.
  • “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.
  • “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (#LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

LCMPI 12-06-14

Profits from Long Call trading returned several weeks ago, a major signal of a return to bullish confidence and strength. Bear markets, even during the strongest bounces, have historically never been strong enough to cause Long Calls to profit. The current presence of Long Call profits therefore places serious doubt that a Bear market ever was ever underway, despite indications from Covered Call/Naked Put Index (#CCNPI) to the contrary. The contradiction is the first of its kind in at least 10 years, so in some ways the S&P is in uncharted territory now.

As long as the S&P closes the upcoming week above 2039, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls have regained confidence and strength. Levels above 2039 would suggest a significant shift in sentiment, notably a huge return of confidence by the Bulls.

Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to create brick-wall resistance, since each high is perceived as a rip to be sold. In a true Bear market, the Bulls will never be confident and strong; thus, Long Calls and Married Puts will never profit during a Bear market. Profits are therefore compelling evidence that the Bulls are firmly in control.

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